The yin and yang of stocks and bonds

Low bond yields fail to spur gains in equities

By

MonicaLee

NEW YORK (CBS.MW) -- An old maxim has long applied to the tug-of-war between stocks and bonds: Low bond yields give investors a stronger incentive to shift assets into the stock market.

That's not the case today, though. While the Treasury's benchmark 10-year note has fallen to its lowest yield in 40 years on the heels of 10 interest rate cuts by the Fed this year, there has been no major push away from bonds and into stocks.

Some investors correlate low yields to a turning point for stock prices since companies can seize the opportunity to borrow money at the low rates -- a move that could help future earnings. But the market has not reached that point.

"Despite the fact Treasury yields have been low and declining, we still haven't seen any particularly good signs of a pick-up in stocks," says John Canavan, market analyst at Stone & McCarthy Research Associates, a bond-research firm. "On balance, the low Treasury yields are good for the economy, but it's not enough to overcome the current negative influences on the economy."

Fixed-income securities, or bonds, promise investors periodic coupon payments throughout the life of the security, plus a lump-sum payment equal to security's face value at maturity. Regular payments are based on the interest rate of the bond determined at the time of the purchase.

When investors are seeking a safe haven from stock market volatility, bonds offer them risk-free dividends. After the stock market crash in October 1987, the fallout triggered the single biggest one-day rally for the Treasury market.

But the reverse is also true. Low Treasury yields, in theory, can help equities rebound. As yields get particularly low, demand for treasuries may drop as investors seek higher returns from the stock market. Yields are determined by the rate of return on a bond, including the total annual interest payments, purchase price, redemption value and the amount of time remaining until maturity.

At the close of trading Friday, the 10-year note was down .350 to 105.47 with a yield of 4.30 percent, and the 5-year note lost .260 to 99.47 with a yield of 3.61 percent. The 30-year bond lost .340 to 107.81 with a yield of 4.87 percent. The U.S. Treasury market was closed Monday in recognition of Veteran's Day.

Low Treasury yields

"The overall economy is still weak enough to support a further moderate decline in bond yields over the next two to three months," says Anthony Karydakis, director and senior financial economist at Banc One Capital Markets.

After the tenth interest rate cut this year, the Federal Reserve still anticipates economic weakness in the foreseeable future, saying that "heightened uncertainty and concerns about a deterioration in business conditions" both in the U.S. and abroad are hurting economic activity.

In addition, studies show that manufacturing activity, construction and consumer spending plunged following the Sept. 11 terrorist attacks.

More severe than economists' expectations, the National Association of Purchasing Management reported a contraction in manufacturing activity. Personal-consumption expenditures faced the largest drop since January 1987, the Commerce Department said. And construction spending tumbled for the fifth consecutive month in September.

"People's expectations are changing because they've lost money in the past two years."
Chris Dillon,J.P. Morgan Chase &amp; Co.

There is no concrete evidence to predict the length or depth of the current downturn, let alone support any renewed commitment to the performance of the stock market. The Fed's easing has not come to an end, and most economists expect the central bank to cut rates another 25 basis points in December to forestall recession.

"People's expectations are changing because they've lost money in the past two years," says Chris Dillon, a vice president at J.P. Morgan Chase & Co in New York. "People don't expect a 20 percent a year return in stocks and the high risk downside is also weighed."

In a balanced environment where bond yields can meet the probable return on stocks, people ought to be indifferent to investing in stocks versus bonds, experts say.

"Stocks and bonds are not a perfect substitution in all environments," Karydakis says. "Different environments have different precautions -- different degrees of risks and concerns."

In the last six weeks, there's been a slight rally in the stock market. But the risks on stocks remain high even given the low bond yields.

"We've used this opportunity to lighten up on our position," says Kari Bayer, quantitative strategist at Merrill Lynch & Co. "Earnings growth is still very weak and fundamentals don't support a rally at this time."

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